IPO activity so far this year is well off the pace compared to this time a year ago. According to Renaissance Capital, as of last Friday, there have only been 16 IPOs in 2016, compared to 45 at this point last year, representing a decline of 71%. Indeed, when cybersecurity firm Secure Works Corp. completed its IPO last Thursday, it was the first tech IPO in over four months – and its debut was less than encouraging, as the offering priced below the targeted range. In an environment like this, companies whose strategies included an IPO may find that their plan to go public is simply no longer a realistic – or even desirable – option.
Among the many consequences that may befall a company whose IPO plans are sidetracked is the possibility that it may face claims from disappointed investors who assert that the company and its senior officials should be held liable to them for their losses arising from the company’s failure to launch. As discussed below, a recently filed lawsuit underscores the susceptibility of pre-IPO companies to these kinds of claims, which in turn highlights some important D&O insurance considerations for these kinds of companies.
The Oriental Dragon Complaint
On April 19, 2016, a large group of investors filed an action in New York (New York County) Supreme Court against Oriental Dragon Corporation, which was formerly known as Emerald Acquisition Corp. The plaintiffs’ complaint can be found here. The defendant company is a Cayman Islands corporation with its principal place of business in China. In October 2009, the defendant company acquired 100% of Merit Times, a British Virgin Islands corporation. Merit Times’s wholly owned subsidiary, MKFB, a People’s Republic of China corporation, in turn controls SL Juice, a fruit juice company in China.
The defendant company raised funds for this acquisition through a $17 million private placement. In their complaint, the plaintiffs allege that in connection with this private placement, the defendant company represented and promised that it would file a registration statement with the SEC in order to complete an IPO and that it would use its best efforts to cause the registration statement to be declared effective. The plaintiffs allege that an agreement accompanying the private placement memorandum explicitly required the defendant company to hold a portion of the proceeds in escrow to be used for the company’s expenses in going public.
The complaint details certain steps the company did take toward completing an IPO. On November 20, 2009, the defendant company did file a registration statement with the SEC. Between November 2009 and November 2010, the defendant company filed multiple amendments to the registration statement. After November 2010, the company filed no further amendments; instead in February 2013, the company withdrew the registration statement, stating in a letter to the SEC that it had “elected not to pursue the sale of securities.”
In March 2014 the company advised the SEC that it was unable to file it annual report because its auditors had been denied the privilege of appearing before the SEC. In May 2014, the company received notice from Grant Thornton that the company’s year end 2012 and certain interim quarterly financials should no longer be relied upon. The company retained an independent auditor, Marcum, to re-audit the questioned financials and certain others. However, in late December 2014, the company terminated Marcum.
The plaintiffs allege that the defendant company “made a series of knowingly false and misleading representations to Plaintiffs with the intent of inducing them to participate” in the private placement offering. The defendant company, the complaint alleges, mispresented that it intended to complete an IPO, when “in fact Defendant never intended to do so.” The plaintiffs’ complaint asserts claims against the defendant company for breach of contract; breach of the implied covenant of good faith and fair dealing; fraudulent inducement; fraud; and unjust enrichment.
The plaintiffs each seek as damages the amounts each individual invested in the private placement (as listed in Schedule I to the complaint), as well as punitive damages against the defendant company for its “morally culpable conduct and reprehensible motives.”
It is always difficult to assess the merits of a case from the bare allegations of the initial complaint, but I will say that based on the allegations, it appears that there could be a significant dispute about whether or not the defendant company breached its obligations. The company did, after all, file a registration statement, as well as several amendments to the registration statement. There could well be a substantial dispute whether or not the defendant company did in fact use its “best efforts” to have the registration statement declared effective, and whether, after the sixth registration statement amendment, a realistic possibility remained that the company could actually complete the intended IPO. The complaint’s allegations about the company’s disputes with its various auditors are serious and disturbing, but at least on the face of the complaint seem to have little relationship about to the company’s failure to complete the IPO. So there could be a fair amount for the parties to fight about here.
While this case will unfold in the coming months and the outcome will remain to be seen, the reason it is of interest now because it represents an example of how a pre-IPO company that fails to complete a planned offering can get hit with a “failure to launch claim.” To be sure, the circumstances in this case are somewhat unusual, and not merely because its international flavor and the various Chinese connections involved. This situation is also unusual because the pre-IPO private offering included an express written undertaking for the company to complete an IPO (or at least to use its best efforts to do so). Pre-IPO company investors will rarely have the type of express expectation interest the plaintiffs here claim.
This case is far from the only recent example of a pre-IPO company getting hit with a failure to launch claim. Indeed, I have written about prior examples on this blog (refer, for example, here and here). In the current IPO market environment, where companies whose strategies include an intended IPO may find that they are unable to execute their IPO plan, the possibility arises that the disappointed investors might, like the investors here, assert claims for damages based on detrimental reliance and frustrated expectations.
When a company is planning an IPO, there is a natural tendency to focus on the public company liability exposures the company will face after its offering is completed. As a result of this potential post-IPO public company liability exposure, a great deal of thought and effort is invested in making sure that the company will have an appropriate D&O insurance program in place when it completes its offering. While this effort and focus is entirely appropriate, it may overlook the fact that the company also potentially may face liability exposures if, like the company here, it fails to complete its offering.
The fact is that if the company fails to complete its IPO plan and it winds up facing “failure to launch” claims, the D&O insurance policy that will respond will be the company’s private company policy, not the public company D&O insurance structure that would have become operational if the company completed the IPO.
The fact that the company’s private company D&O insurance policy will be the one that will have to respond to any “failure to launch” claim has important implications for a pre-IPO company’s policy’s terms and conditions. It will be particularly important the policy’s terms and conditions take the possibility of these kinds of claims into account.
To cite just one example of the kind of provision that will have to be reviewed carefully to make sure the policy responds appropriately to a failure to launch claim, the company’s Securities Exclusion should be reviewed to ensure that it does not exclude liabilities that could arise from pre-IPO activities, such as roadshow activities, or pre-IPO documents, materials, or statements. (Ideally, the private company D&O policy’s Securities Exclusion will state that it will only apply when and if the company’s registration statement is declared effective by the SEC.)
Often the senior management of companies on an IPO trajectory are unwilling to take the time to address D&O insurance issues before the company is deep into the IPO process, and even then (if at all), it is usually with a focus on the public company exposures the company will face when its IPO is completed. But as the example above shows, claims can and do arise in connection with a company’s pre-IPO activities. The pre-IPO period is a potentially significant part of a company’s life cycle and for that reason it is particularly important for companies in this life cycle phase to have a skilled and experienced insurance professional involved in designing their insurance program, well before the time of the planned IPO.
Upcoming Quarterly Claims Trend Webinar: On Tuesday, April 26, 2016, I will be participating in Advisen’s Quarterly D&O Claims Trend webinar. This free webinar will begin at 11:00 am EDT and will last one hour. The webinar panel will also include Laura Coppola, Allianz’s regional head of commercial management liability for North America; Jim Illardi, Allianz’s regional head of financial lines claims for North America; and Maurice Pesso of the White & Williams law firm. The session will be moderated by Advisen’s Jim Blinn. Information about the webinar including registration instructions can be found here.